John Rothe's  Instablog

Despite last week's decline in the US stock market, the S&P 500 index still remains in its Fed induced, euphoric upward trend.

The multi-month trend in the S&P 500 was successfully tested last week, indicating that equity traders are not ready to believe that the Fed will be reducing monetary stimulus anytime soon.

The US bond market, however, is telling a different story. US bond prices continue to fall and are at a "line in the sand" moment. Bond traders may be looking for a short term reversal at current levels - but if a reversal fails to appear, equity prices may quickly reverse to the downside.

Sector strength relative to the S&P 500 is starting to narrow as Consumer Discretionary, Financials, and Healthcare are the only three sectors outperforming the market.

Breaks in the current multi-month trend may be an indication that investors are protecting year-to-date profits in their portfolios as we enter summer - a historically slow period of the year - and would rather stay on the sidelines until the future of the Fed's monetary policy becomes more clear.

Despite last week's decline in the markets, the S&P 500 still remains in an aggressive upward trend.

SPX Weekly Chart (SPY):

(click to enlarge)

(source: Riverbend Investment Management)

Early signs of weakness may be indicated by a break in the multi-month trend in S&P 500 daily trend, which was successfully tested last week - indicating traders still want to be long this market.

SPX Daily:

(click to enlarge)

(source: Riverbend Investment Management)

Bond prices are still in a downward trend - but are at a level where we may see a short term reversal.

A break below the trendline may spook equity investors and cause a more dramatic pullback in equity markets.

(TLT) Weekly:

(click to enlarge)

(source: Riverbend Investment Management)

The US dollar still remains in sideways, consolidation pattern. Dollar investors may be taking a "wait and see" approach, but ultimately the US dollar is still the default global currency.

"UUP" (Proshares US Dollar Index) Weekly:

(click to enlarge)

(source: Riverbend Investment Management)

However, strength in the market is starting to narrow as sectors outperforming the S&P 500 are down to three.

Consumer Discretionary (XLY):

(click to enlarge)

(source: Standard and Poor's)

Financials (XLF):

(click to enlarge)

(source: Standard and Poor's)

Health Care (XLV):

(click to enlarge)(source: Standard and Poor's)

Disclosure: I am long SPY, TBF, XLF, XLV, XLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

For the past year, investors have been enjoying a low-volatility environment, allowing many to see gains without worry or sleepless nights. However, I believe this euphoria will be coming to an end shortly. In his 2013 outlook, bond manager/guru Jeff Gundlach referred to the status of the markets as a "coiled snake ready to strike". I agree wholeheartedly with this analogy. You can see what he is talking about when taking a look at the VIX:

(click to enlarge)

The VIX, which measures market volatility and is sometimes referred to as the "fear gauge", is still at a very low level. With earnings season getting underway and the anticipated start of debt ceiling discussions, I would expect higher levels of volatility in the market. It is also interesting that there doesn't seem to be a great deal of hedging either, but this trend looks like it is beginning to change. I like to look at volume levels of various inverse ETFs, such as the Proshares Short S&P 500 fund, to help gauge expected market direction:

(click to enlarge)

While slow rising, these inverse ETFs are still showing low volume levels, which may indicate that investors are talking a wait and see approach to the market - hoping that they will be nimble enough when the time comes to jump back in. Unfortunately, scenarios like this usually indicate that the market will move violently in either direction as everyone reacts at the same time... like a "coiled snake" striking.

Markets Are Overbought

US equities appear to be overbought. Although markets can stay overbought for some time, the NYSE High Low index is running very high when compared to the last three years.

(click to enlarge)

S&P 500 Is Weighted Toward High Beta Names

One major concern I have is the high beta names in the top 10 companies that make up the S&P 500 index. Investors are clearly over-weighted in riskier asset classes.

(click to enlarge)

Source: S&P
In addition, bond prices on the other end of the risk curve appear to be breaking down:

(click to enlarge)

The breakdown may be partially caused by investors reallocating their portfolios into equities. Some money is going into high beta names, but I am seeing inflows into dividend-paying stocks as well. If this shift causes bond yields to start rising, the market may become spooked that the Fed is losing their ability to control the yield curve. And this trend of moving money away from bonds and into equities will quickly reverse.

Apple: Will History Repeat Itself?

Apple makes up a large percentage of the tech sector and is currently the second largest stock in the S&P 500 index by capitalization. (Apple just lost the #1 position after its month-long decline.) Its share price may follow the same boom/bust pattern as Microsoft:

(click to enlarge)

(click to enlarge)

source: Bespoke Investment Group
Investors should keep a close eye on Apple. Apple led the market up and may very well lead the market lower. Just like Microsoft did in the late 1990's and early 2000's. I am hearing similar arguments as to why Apple's stock price will continue to rise as I did with Microsoft in 1999. And we know how that turned out.

Not Just Tech:

Lastly, the technology sector isn't the only area which looks overbought. Sectors that make up the largest weightings of the S&P 500 are looking very lofty:

(click to enlarge)

The US equity markets are still rising since the start of 2013. However, our models have not been overly bullish in this environment.

Last week, bond manager/guru Jeff Gundlach made a presentation where he referred to the status of the markets as a "coiled snake ready to strike".

You can see what he is talking about when taking a look at the VIX:

(click to enlarge)

The VIX, which measures market volatility and is sometimes referred to as the "fear gauge", is still at a very low level. With earnings season approaching and the anticapted start of debt ceiling discussions, I would expect higher levels of volatility in the market.

I also find interesting that there doesn't seem to be a great deal of hedging going on either.

I like to look at volume levels of various inverse ETFs, such as the Proshares Short S&P 500 fund, to help gauge expected market direction:

These inverse ETFs are showing low volume levels, which may indicate that investors are talking a wait and see approach to the market - hoping that they will be nimble enough when the time comes.

Unfortunelty, scenarios like this usually mean the market will move violently in either direction as everyone reacts at the same time.

This is probably a good time to start hedging portfolios in case the coiled snake does strike…